Public Pension Troubles Loom for State and Local Governments

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We have watched with trepidation as the stock market declines and along with it the value of our retirement accounts. Yet with our personal accounts, it’s our own problem. When it comes to public pensions, it’s the taxpayer’s problem. Underfunded pensions could cut two ways, leading to much higher taxes and/or cuts in government spending.

This is a particularly big issue here in my home state of Illinois. The Chicago Sun-Times just reported the Land of Obama has earned the dubious honor of having the most underfunded public pension plan in America.

According to Professor Jeremy Siegel, the above-average returns of the stock market in the recent past have attracted the attention of public pension fund managers.

The prospect of bigger returns has led managers to pour billions in public pensions into stock. Finance Professors Deborah Lucas and Stephen Zeldes report that the share of state and local (S&L) plan assets held in equities has greatly increased over time from an average of about 40 percent in the late 1980s to about 70 percent in 2007.

In the current market environment, this exposure led to a loss of an estimated $1 trillion dollars over the past year. Are stocks likely to average annual returns of 10% for the next 20 years? Not likely, and that’s a big problem for both public pension funds, and for the poor taxpayer.

Equity investing will see many challenges in the coming years. Here are some issues to consider. The reaction to Enron’s bankruptcy was much tighter regulation on corporate accounting. This led to the infamous Sarbanes-Oxley law which has made it far less desirable to run public investment funds and slowed the development of new IPOs. The result, as Joe Weisenthal reported in February of 2007, was a spectacular rise in private equity funds, such as the infamous hedge funds, which contributed mightily to the recent financial meltdown.

Successful IPOs eventually join the major indexes which help the long run drive equity returns. Fewer IPOs mean less opportunity for investing in listed equities. This will make it harder for pension funds to enjoy higher returns.

And then there are some demographic concerns. In 2008 the first cohort of baby boomers retired. Many more will follow. This will put increasing strains on all equity investors. Eventually, pension fund managers will have to be net sellers of equities to raise cash for the retiring boomers. No one can say with certitude when this trend will hit critical mass, but when pension funds become net sellers stocks are almost certain to go down.

The giant bull market of 1982-2000 was driven not only by favorable demographics but also lower marginal income tax rates, cuts in capital gains taxes, and lower inflation. All three conditions could very likely be much higher in the next 20 years. President Obama has openly talked about higher capital gains taxes and the rich being obligated to fund expanded government programs. Recent increases in the money supply by the Federal Reserve Board point to potentially much higher rates of inflation and interest rates. Equities will perform poorly in such an environment.

American equity investors are in a new era with the federal government making direct investments in private companies. What are the likely results of the federal government controlling an industry? Not good. The TARP program quickly expanded to taxpayers funding car companies that under normal market conditions would have been forced into bankruptcy. What other industries does the federal government have in mind for taking over? Is the medical industry next? Drug companies? Until recently these scenarios were unimaginable.

All this uncertainty, at very least, is quite bad for equity investing.

The TARP program is likely to have profound long-term affects on capital markets. With the government having a big stake in major banks, future business loans could potentially be influenced by politicians who regulate the banks. This will lead to a massive misallocation of resources. Will the federal government encourage more homeownership when the housing market has a huge supply? Only time will tell. Will a bank branch be allowed to close in a powerful Congressman’s district?

As equities lose their attractiveness, public pensions may have to look to corporate bonds and real estate to get investment returns. Are these investments likely to produce historical rates of return that equities have? It’s very unlikely. Governments may be forced to conduct fire sales of their properties just to raise cash to meet their pension obligations.

Something will have to change. Without a restored boom in stock prices, public pension funds will have a very hard time meeting their obligations. Either governments will have to increase taxes – perhaps dramatically – or force public employees to endure the same risks and potentially anemic returns the rest of us may be up against. Given the size of these funds, and the enormous political power of government workers, this may create one of the major political conflicts of the coming decade.

Steve Bartin is a resident of Cook County and native who blogs regularly about urban affairs at http://nalert.blogspot.com. He works in Internet sales.